The Millennium Challenge Corporation Compact Addressing constraints to growth

Originally published in Daily News

By Ravi Ratnasabapathy

On April 25, 2019, the board of the MCC (Millennium Challenge Corporation) approved a Sri Lanka Compact – a five-year, US $480 million grant. The grant seeks to assist the Government to address two of the country’s binding constraints to economic growth:

1. inadequate transport logistics infrastructure and planning; and

2. lack of access to land for agriculture, the services sector, and industrial investors.

Controversy has surrounded foreign loans taken by the government, which now faces difficulty in repaying them. The MCC compact, however, is a grant, so it does not need to be repaid which is a plus.

What does the MCC Compact involve?

The idea is to stimulate growth by addressing two critical areas that are constraining it. The two areas were identified by a study conducted by the Center for International Development at Harvard University. The study which took almost a year was conducted throughout 2016 and based on “Growth Diagnostics” a methodology developed by Ricardo Hausmann, Dani Rodrik and Andrés Velasco to determine the obstacles to a country’s capacity to grow.

“The main idea is that each country may be bumping against different potential constraints but each constellation of constraints must be giving off a different collection of symptoms or signals. By using Growth Diagnostics, policymakers can develop a clearer theory of change by designing policies that can take the country out of (or workaround) its current syndrome and relax its most binding constraints.” (Harvard CID)

High levels of government spending have helped drive growth over the past decade- services comprise 62% of GDP and are dominated by government spending. Manufacturing makes up only 29% of GDP and agriculture makes up the rest. It is not feasible to rely on government spending to drive growth any longer because:

• Tax revenues are very weak (only 11.9% of GDP in 2018)

• Budget deficits are high (5.3% of GDP in 2018) and

• Debt is high (central government debt was 82.9% of GDP in 2018)

If government spending is to increase (eg: by hiring new people to the public service or embarking on infrastructure spending) it requires either increased tax revenues or increased debt. The current regime has increased taxes across the board (VAT, PAL, income tax etc.,) to try and increase government revenue. Naturally, this has proved highly unpopular. If tax revenues are not available the government can borrow and spend, but with debt levels already high this is not an option either. People must also understand that debt is not “free” money – it must be repaid-out of future taxes. In effect debt is simply taxation postponed – we can spend today but taxes must go up tomorrow to repay the debt.

Simply put, the current basis of growth, driven by public sector spending is not sustainable. Therefore new avenues of growth must be found.

A key driver of growth in successful East Asian economies was exports. It was also an important driver of Sri Lanka’s growth in the 1980s and 1990s. Exports of manufactured goods grew very rapidly, at around 20% annually between 1976 and 1984. Following the outbreak of the civil war, growth slowed drastically during the next five years, but then accelerated to an average rate of 16% between 1989 and 2000. Since then, however, growth stagnated and exports have declined in importance. As a % of GDP exports have fallen steadily from a high of 33.3% of GDP 2000 to about 12.7% of GDP in 2016.

Export growth

One of the problems to growth in exports faced by Sri Lanka is the lack of diversification. Exports grow not only because of volumes but also because new products being added to the basket. Between 2000-2015 Sri Lanka added just 7 new products (worth US$ 0.1bn) to its export basket. In contrast, Thailand added 70 new products (worth US$ 21.8bn) and Vietnam 48 (worth US$ 50.4bn).

The possibilities of exporting related products within Sri Lanka’s existing export basket seem exhausted so completely new sectors must be attracted, which is not easy.

Reinvigorating the export sector is thus a priority. Bringing in new investment (local and foreign) to export industries, particularly in new sectors can create a new path to growth. What is holding back investment? The Harvard study identified the following:

1. policy uncertainty (especially tax and tariff policy);

2. inadequate access to land; and

3. poor transportation and logistics

The most important is policy uncertainty. As the study points out:

“policy uncertainty as it relates to taxes is characterized by an accumulation of contradictory announcements from various government officials on a range of taxes, including trade-related taxes….policy uncertainty is higher in Sri Lanka than in comparator countries and that investor optimism deteriorated as contradictory statements mounted.”

Unfortunately little can be done to address the policy uncertainty (the government needs to get its act in order) but the MCC grant addresses the other two.

As per the analysis:

“The potential new industries and services that will drive Sri Lanka’s future growth need high-quality industrial land with integrated infrastructure, including access to wastewater services, stable electricity supply and the ability to move goods reasonably quickly. Currently, such a combination (i) is hard to obtain in the congested Western province, (ii) is located in areas that are not sufficiently connected to other parts of the island, a fully-functioning port or airport, or people with adequate skills, or (iii) does not yet exist.”

Specifically with respect to land:

“Consultations with the private sector reveal that transaction costs to access industrial land are very high for domestic investors and foreign investors alike, but that domestic investors are advantaged by a more intimate knowledge of the system. The inability to secure land for planned investment activities has been the most common cause of investment plans being dropped or relocated to other countries in the last several years according to continuous consultations with the private sector by CID and government teams that it has worked alongside.”

A partial solution to this would be to develop industrial zones with adequate facilities. The country currently has 12 zones but most are already filled- itself is a testament to the problem. While more industrial zones will help, it does have the limitation that growth will tend to cluster in pockets around the zones, rather than being more widely spread.

Lack of transport infrastructure

The lack of transport infrastructure-critically access to the port and airport means that the majority of industries are crowded around the Western province.

“The Western Province also hosts the major logistics centres upon which other regions of the island are currently dependent in varying degrees. Consequently, the movement of goods and people within the province is increasingly problematic, imposing mounting costs and physical limitations on growth prospects in that part of the country. This, in turn, hurts the growth prospects for other regions to the extent that these regions depend upon access to logistic centres and markets concentrated in the Western Province.”

This leads to problems of congestion, high prices and uneven development, as other parts of the country get left behind. Building transport infrastructure to link up other parts of the country is therefore important.

“Connectivity concerns are also relevant in other regions of the country. The current state of transport infrastructure generally frustrates the development of inter-regional economic activity and arguably the suitability of locating investments outside the western region and near other concentrations of the population on the island. Economic development in other regions would help reduce the constraints that congestion (as it affects travel time costs, labour availability, and access to land) imposes upon growth in the western region as well as promote more inclusive and geographically widespread growth.”

It is also important to try and ease the congestion within the Western province by the efficient provision of public transport and improved traffic management. “Problems associated with congestion are expected to worsen with a high degree of certainty. Daily average road speeds in Sri Lanka (Colombo District) are estimated to decrease from 26 km/hour to 19 km/hour (22 km/hour to 14 km/hour) between 2011 and 2031. Peak hour speeds are forecast to be as low as 11 km/hour and 9 km/hour in Sri Lanka and Colombo District, respectively.”

The concept of evidence-based policymaking is unknown in Sri Lanka. Interventions are made overnight by politicians succumbing to pressure from special interest groups or their own whims and fancies. The MCC Compact is a result of careful analysis and addresses some important issues. The detailed studies on which it is based are available on the Harvard CID and MCC websites. It would be a pity if this were to fall victim to uninformed fear-mongering and petty politics.